Aggregate D&S II

Economic Spectrum Money Supply is Important Determinant of Economic Output Government Spending (Fiscal Policy) is Important Determinant of Economic Output Free Markets Work Government Policy Works Monetariasts Keynsians X Activist (Keynsian) Monetary Policy

Deflation Nearly all economists agree deflation is at least as bad as inflation With deflation, greater defaults on loans Greater bank failure Capital cannot be channeled to good investments Real output declines May have long run effects

Growing the Money Supply Both Keynsians and Monetariasts: Err on the side of inflation Keynsian (activist) Time monetary policy to stabilize prices and output Monetariasts Grow money supply at a small constant rate. Result will be moderate inflation from year to year, but benefit will be somewhat of a hedge against deflation. Any other efforts to “time” policy will simply result in greater volatility in output.

Monetariast Critique of Keynes Government does not always act in our best interest Example: Government spending binges bring short- term gain at cost of high inflation Government cannot act before prices adjust Example: Government spending only creates greater volatility in output

Governments and Self-Interest Aggregate Output, Y P Government spending shifts demand to right

Governments and Bad Timing Aggregate Output, Y P 2. 1&

Free Markets Great depression generated distrust of free markets Shift to quasi-socialism In general, the world is learning that free markets (prices) do a better job allocating resources than governments. Deregulation of airline industry in U.S. Privatization of mining in U.K.

Free Markets The invisible hand cannot always be left to work on its own however. Free-rider problem Externalities Adverse selection

Governments & Monetary Policy Because of adverse selection, governments should take the role of printing money. Some kind of policy is needed. 1) Gold Standard 2) Passive (Monetariast) policy Friedman: grow money supply at constant rate 3) Activist (Keynsian) monetary policy Time money supply to control inflation and minimize fluctuations in output

Gold Standard Governments print money backed by gold Money supply is affected by supply of gold Governments lose control over monetary policy – Government is subject to temptation to print more currency than it has in gold reserves. Leads to “runs on the central bank” and currency devaluation. If government can be “trusted”, at least a passive monetary should be preferred

Effective Central Banks Independence from political pressure Control over own budgets Policies must be irreversible Decision making by committee Risk of putting one person in charge can be high Accountability and Transparency Establish a system of goals Publicly report progress

Passive Policy Why not just passively grow the money supply at a constant rate? Could potentially lead to greater price stability than gold standard. Money supply is measurable, and the central bank could be held accountable for its actions. However, the primary goal of monetary policy is to control inflation. The relationship between money supply and inflation is far from exact.

Money and Inflation M2 Growth Rate and CPI Inflation Rate 2 years later.

Current Approach Congressional legislation dictates Fed to actively determine monetary policy to achieve maximum employment stable prices moderate long-term interest rates How do we know it works? Monetariasts: active policies may simply add to volatility of output and prices

Equilibrium Keynsians: Wages are sticky. Short-run aggregate supply is slow to shift, particularly when unemployment is high. Government is needed to restore economy to equilibrium. Monetariasts: Wages are not sticky Best thing to do is to leave economy alone

Case 1: SRS Shifts Left Consider a natural disaster that destroys oil refineries. Cost of oil increases. This causes the SRS curve to shift left Result: Lower output Higher prices (inflation)

Case 1: SRS Shifts Left Aggregate Output, Y P 2. 1.

Case 1: Keynsian View Wages are slow to adjust, so the economy can stay out of equilibrium for several years. This is believed to be particularly true when the labor market is slack Unions, for example, prevent employers from lowering wages Increased money supply can increase aggregate demand. Lower unemployment (higher output) at the cost of inflation. Keynsian view: benefit outweighs costs

Case 1: Keynsian View of Government Action Aggregate Output, Y P

Case 1: Monetariast View Wages adjust rather quickly – at least faster than the government has time to act. Correct action is to let the economy alone. If government acts: Increased volatility of output and prices Inflation

Case 1: Monetariast View of Government Action Aggregate Output, Y P 2. 1&

Case 1: Monetariast View of No Government Action Aggregate Output, Y P 2. 1&3

Non-activist Argument Data Lag – it takes time for policy makers to obtain the data that tell them what’s going on. Data on quarterly GDP not available for several months until after the quarter. Recognition lag – it takes time for policy makers to realize what the data is saying about the future. NBER won’t classify the economy in a recession until 6 months after it determines one might have begun. Effectiveness lag – Once money supply has changed, it can take time for effects to be carried out

Case 2: AD Shifts Left Keynsians: AD curve shifts left with Decrease in money supply (bank failures) Irrational pessimism by consumers Monetariasts: AD curve shifts left with Decrease in money supply (bank failures) Result: Lower output Lower prices (deflation)

Case 2: AD Shifts Left Aggregate Output, Y P 2. 1.

Case 2: Keynsian View Wages are slow to adjust, so the economy can stay out of equilibrium for several years. This is believed to be particularly true when the labor market is slack Unions, for example, prevent employers from lowering wages Increased money supply can increase aggregate demand. Lower unemployment (higher output) Prices restored to original level

Case 2: Keynsian View of Government Action Aggregate Output, Y P 2. 1&3

Case 2: Monetariast View Wages adjust rather quickly – at least faster than the government has time to act. Correct action is to let the economy alone. If government acts: Increased volatility of output and prices Inflation

Case 2: Monetariast View of Government Action Aggregate Output, Y P 2. 1&

Case 2: Monetariast View of No Government Action Aggregate Output, Y P

Case 3: AD Shifts Right Keynsians: AD curve shifts right with Increase in money supply (loose credit) Irrational exuberance by consumers Monetariasts: AD curve shifts right with Increase in money supply (loose credit) Result: Tight labor market Higher prices (inflation)

Case 3: AD Shifts Right Aggregate Output, Y P 2. 1.

Case 3: Keynsian View Wages are slow to adjust When they do, result will be high inflation Decreased money supply can decrease aggregate demand. Output restored to equilibrium Prices restored to original level

Case 3: Keynsian View of Government Action Aggregate Output, Y P 2. 1&3

Case 3: Monetariast View Wages adjust rather quickly – at least faster than the government has time to act. Correct action is to let the economy alone. If government acts: Increased volatility of output and prices Deflation

Case 3: Monetariast View of Government Action Aggregate Output, Y P 2. 1&

Case 3: Monetariast View of No Government Action Aggregate Output, Y P

Successful Active Monetary Policy New Zealand Canada United Kingdom United States